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The Impact of inflation

Considering inflation and its effect on Investments and Pension income

When you consider either an investment or your
future pension income it is crucial that you consider the impact of inflation on
that investment. Below we consider both inflation when planning for retirement
and inflation in retirement:

Inflation when planning for retirement

Most of us are well aware that investments which
pay fixed interest rates often struggle to keep pace with inflation over time,
especially if we are taking the interest as income and therefore the purchasing
value of our original investment is depreciating all the time.

However asset backed investments, such as stocks
and shares, have in general historically beaten inflation over the medium to
long term.

Asset backed investments.

Asset-backed Investments are just about the best
way for you to combat the effects of inflation on your investments, let us look
at a historic example to illustrate the point.

Let us imagine that in 1992 you won
£600,000 on the lottery. You decided to invest your winnings in the following
ways:-

1. The first £200,000 you used to buy a home,
outright ( a 3 bedroomed semi-detached house in a suburb of London).

2. As luck would have it, the property next door
was also for sale and so you bought that and let it out, getting a rental yield
of 5% (.i.e. £10,000.00 a year, or £833.33 per month).

3. The last £200,000 you deposited with the XYZ
Building Society, getting an income of 8.65% (i.e. £17,300.00 a year).

Let us assume that you decided to retire and you
spent the £20,000 income (i.e. both the rent from the house and the income from
the Building Society) to fund your cost of living.

Now, let’s roll the clock forward 20 years to 2012
and see what has happened:-

1. Your house is now valued at £632,173 (figures
from the Nationwide Property Index).

2. Your investment property next door is also
valued at £632,173 and your rental yield is still 5%, i.e. £31,608
(approximately £2,500 per month).

3. Your deposit with XYZ Building Society is still
only worth £200,000, but the income has now fallen to 2.75% i.e. £5,500 per
annum (figures from Sources: 'Annual Abstract of Statistics' 2000 edition.
Office for National Statistics. Building Societies Yearbook 1997-1998'. Official
handbook of the Building Societies Association. Halifax and Nationwide
web-sites)

Your cost of living has now gone up to £36,000.00
per annum, due to inflation over the 20 years (source: The Retail Prices
Index (RPI) inflation measure is used — the historical inflation data comes from
the 2004 paper ‘Consumer Price Inflation Since 1750’ (ISSN 0013-0400, Economic
Trends No. 604, pp 38-46) by Jim O’Donoghue, Louise Goulding, and Grahame
Allen).

The Lesson : Had you relied purely upon deposit
based investments to fund your retirement, you would have a SERIOUS problem.

In our section on
investments we attempt to explain in simple terms all the different asset
backed investments open to the individual investor, from contribution levels
right through to taxation treatment of each investment.

Inflation in retirement

Inflation is one of the biggest threats we face in
retirement but few of us truly appreciate the speed with which inflation erodes
value. Someone retiring at 65, will potentially have a period of their life
whereby their income will be slowly eroded by inflation, unless they have their
investments in assets as described above which are capable of keeping up with
inflation (i.e. asset backed investments).

The inflation rate
experienced in retirement has also been higher than that experienced by younger
members of the population in recent years because of the profile of spending in
later life on products and services that have risen more steeply.

To get a feel for the impact
of inflation just take a look at the table below:

Inflation impact
over 20 years

Income requirement

After
20 years

Annual inflation of 3%

£20,000

£35,070

It’s important to bear the scale of change in mind
when we look at figures relating to income in retirement and decisions about
levels of escalation we might need each year.

The Rule of 72

In finance, the rule of 72 is a method for
estimating an investment's doubling time. 72 (i.e. the rule number) is divided
by the interest percentage per period to obtain the approximate number of
periods (usually years) required for doubling. Although scientific calculators
and spreadsheet programs have functions to find the accurate doubling time, the
rules are useful for mental calculations and when only a basic calculator is
available.

Similarly, to determine the time it takes for
the value of money to halve at a given inflation rate, divide the rule number (i.e. 72) by
that rate.

Example : To determine the time for money's buying
power to halve, simply divide the rule-number by the inflation rate. Thus at
3.6% inflation using the rule of 72, it should take approximately 72/3.6 = 20
years for the value of a unit of currency to halve, in real terms.

This is a very important principle for all of us
approaching retirement to remember, as inflation is one of the biggest threats
that we will face. So when we are putting our pension into service, for example
by turning our pension fund into an annuity, we need to take inflation into
account and probably build some level of escalation into the annuity payments.